FAIR VALUE ACCOUNTING:
VISIONARY THINKING OR
OXYMORON?
Aswath Damodaran
Three big questions about fair value accounting
Why fair value accounting?
¨  What is “fair value”?
¨  What are the first principles that should govern fair
value accounting?
¨ 
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Why fair value accounting?
Three points of view…
The Dreamer: To make accounting value (book
value) a reasonable measure of the true value of a
company.
¨  The Pragmatist: If we mark assets up to fair value,
investors will have a better idea of what a firm is
worth and there should be therefore less uncertainty
about the true value and lower variance in that value.
¨  The Marginalist: Fair value accounting, even if
imperfect and noisy, will provide investors with
useful additional information which they can use to
estimate value in a company or assess its risk.
¨ 
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1. A New World Order
Accountants as the final arbiters of value!!
There are some (accountants, theorists and others)
who believe that it is possible to replace the current
accountant balance sheet with one that reflects the
true value of the company.
¨  In their vision, investors would not look at the market
to assess the fair value of a company but at
accounting statements.
¨ 
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The traditional accounting balance sheet…
Valued based upon motive for
investment – some marked to
market, some recorded at cost
and some at quasi-cost
Assets are recorded at original cost,
adjusted for depreciation.
The Balance Sheet
Assets
Liabilities
Fixed Assets
Current
Liabilties
Current Assets
Debt
Debt obligations of firm
Investments in securities &
assets of other firms
Financial Investments
Other
Liabilities
Other long-term obligations
Assets which are not physical,
like patents & trademarks
Intangible Assets
Equity
Equity investment in firm
Long Lived Real Assets
Short-lived Assets
True intangible assets like brand name, patents and customer did
not show up. The only intangible asset of any magnitude
(goodwill) is a plug variable that is of consequence only if you do
an acquisition.
Short-term liabilities of the firm
Equity reflects
original capital
invested and
historical retained
earnings.
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The intrinsic value balance sheet
Recorded at intrinsic
value (based upon cash
flows and risk), not at
original cost
Assets
Existing Investments
Assets in Place
Generate cashflows today
Includes long lived (fixed) and
short-lived(working
capital) assets
Expected Value that will be
created by future investments
Growth Assets
Liabilities
Debt
Equity
Value will depend upon magnitude of growth
investments and excess returns on these
investments
Fixed Claim on cash flows
Little or No role in management
Fixed Maturity
Tax Deductible
Residual Claim on cash flows
Significant Role in management
Perpetual
Livesvalue of equity,
Intrinsic
reflecting intrinsic value
of assets, net of true
value of debt
outstanding.
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The “market value” balance sheet
A Market Value Balance Sheet
Assets
Existing Investments
Generate cashflows today
Expected Value that will be
created by future investments
Liabilities
Investments already
made
Debt
Investments yet to
be made
Equity
Assets recorded at market value, i.e, what
investors will be willing to pay for the assets
today (rather than original cost or intrinsic value)
Borrowed money
Owner’s funds
Should equate to market value
of equity, if publicly traded.
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Accounting Balance Sheet = Intrinsic value
Balance Sheet: The impossible dream!
¨ 
¨ 
¨ 
¨ 
Even in a well functioning market, there will be a divergence
between intrinsic and market value of both assets (and equity).
The dreamer has to first decide which balance sheet he would
like the accounting balance sheet to converge on.
Even if we were able to write up every asset to intrinsic value,
all that we will obtain is the fair value of the assets in place of
a company.
Growth assets will be either impossible to value (since they do
not exist and may not even be identified yet) or valued
haphazardly.
Bottom line: Fair value accounting, even if done precisely,
will create a two tier system, providing accounting values that
are close to true value for mature businesses and divergent
values for growth businesses.
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2. Fair value accounting = Lower volatility in
markets
¨ 
¨ 
Fair value accounting has had its deepest roots in the financial
service businesses, where mark to market has been part of
accounting practice for several years now. If the premise of
fair value accounting is right, the variance in stock prices
should be lower for financial service firms than for otherwise
equivalent (in terms of size and maturing) industrial
companies.
Some countries have been quicker to jump on the fair value
bandwagon than others. In particular, many countries with
high inflation currencies adopted variants of the fair value
accounting approach, allowing companies to revalue assets at
least to current replacement cost. If the hypothesis is right,
securities in these countries should be less volatile than
securities elsewhere.
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Less volatility.. Says who?
¨ 
While it may be a little unfair to use the current crisis to make any long
standing arguments, the securities with the most volatility were, in face,
stocks in financial service companies that marked-to-market.
¤ 
¤ 
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Marking to market gave little or no advance indication of problems to come.
Even more problematic was the feedback loop created by marking to market in a
sliding market. Markets dropped and book values were written down. As book
values were written down, investors worried about regulatory capital ratios being
breached, which led stock prices to drop even further.
Even controlling for inflation differences, there is no evidence of lower
stock price volatility in countries that adopted inflation accounting. On the
the contrary, stock prices were often more volatile in these countries.
Bottom line: The acceptance of fair value accounting is going to do little to
dampen stock price volatility. It may actually increase it.
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3. Useful information for investors!
¨ 
¨ 
Accounting rule changes have been motivated to either protect
investors (by providing warnings about dangers lurking in a
company) or to provide information to investors (so that they
can better assess value). Thus, rules about showing pension
obligations on balance sheets are protective, whereas rules
about estimating the impairment of goodwill are designed to
provide information.
The ultimate test of whether investors actually find these rules
to be protective or informative comes from how they react to
changes in these numbers. For instance, if there is information
in the impairment of goodwill, we should expect to see stock
prices react to news about impairment.
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Do investors care about accounting changes?
SFAS 121 versus SFAS 142
¨ 
¨ 
In 2002, the accounting standards governing goodwill measurement and
reporting were changed. In particular, firms were required to estimate the
fair value (as opposed to undiscounted cash flows) of acquired firms (and
hence goodwill) every year (instead of when significant events occurred).
The intent was to make the goodwill number more informative to
investors.
A study of stock price reactions to goodwill impairments(>5%) compared
impairments and reactions in 1996-2001 (the SFAS 121 regime) with
impairments in the second half of 2002 and all of 2003. It found that:
¤ 
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Goodwill impairments, on average, cause stock prices to decline albeit by about 3%
(in the two days around the impairment charge).
The decline is larger for firms with fewer analysts (more informational content?) and
for larger firms (better assessments?), but has little or no correlation with the
complexity of the firm.
The effect on the stock price of goodwill impairments dropped significantly (about
1.2%) in the 2002-03 period, after the adoption of SFAS 142.
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Why is there so little information in accounting
changes?
Takes too long: Accountants are deliberative. They take time
to make their judgments. By the time they do, though, markets
already have priced in the information.
¨  Too structured: Accounting rules have to be structured to
prevent the unethical 10% from taking advantage of them.
Every rule takes away some of the discretionary power that
makes a valuation a “good” one.
¨  Mixing of the large with the small: The nature of accounting is
to worry just as much about the small items as the large ones.
The end result is an information dump, where investors have a
difficult time separating what matters from what does not.
Bottom line: If investors wait for accounting statements to tell
them what is happening in real time in a firm, it is already too
late.
¨ 
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Fair Value: What is it?
¨ 
¨ 
While the notion that fair value is in the eye of beholder
is too loose for my taste, the fair value of an asset or
business can vary depending upon how it is defined.
It can be different, depending upon the following:
How you value: Intrinsic versus Relative Valuation, and within
relative valuation, depending upon what you value it relative to.
¤  Who you value it for: The valuation can be different depending
upon whether you are valuing it for a passive investor or an
active investor, and whether and what the latter plans to do with
the asset.
¤  For transaction or appraisal: The value attached to an asset can
be different depending on whether you are planning to sell the
asset or hold on to it for its cash flows.
¤ 
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A Test: Estimate the fair value of this companyIntrinsic Value
Revenues
- Operating Expenses
- Depreciation
Operating Income
- Taxes
Expected next year (in millions)
$400
$250
$30
$120
$40
Operating Income after taxes
¨ 
¨ 
$80
Operating income is expected to remain the same (zero
growth) forever (perpetuity). Capital expenditures offset
depreciation and there are no working capital requirements.
The firm is all equity funded and has a cost of equity of 10%.
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Estimate the fair value again: Different
management
¨ 
Assume now that the firm, run by superior (optimal)
management, would make the following changes:
¤  The
after-tax operating margin will increase to 25% (from
20%). As a result the after-tax operating income would be
$100 million instead of $ 80 million.
¤  Changing the mix of debt and equity will lower the cost of
capital to 8%.
¨ 
What is the intrinsic value of the firm, with new
management?
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“Expected” Intrinsic Value
We have two estimates of fair value - $ 800 million
with the status quo and $1,250 million with optimal
management.
¨  Assume now that there is a 40% probability that the
management of this firm will change and a 60%
probability that it will not. In an efficient market,
what is the “expected” intrinsic value of this firm?
¨ 
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And again: Relative Valuation
Now assume that the firm is a mid-size chemical
company and that publicly traded mid-size chemical
companies trade at 5 times EBITDA.
¨  Given that this firm is expected to have EBITDA of $
150 million, estimate the value of the firm.
¨ 
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Yet again: For sale now!
Now as a final estimate, assume that equity markets
are fairly illiquid right now and that selling the entire
business today can be accomplished only by
discounting the value.
¨  If the illiquidity discount is 20% on estimated value,
estimate the expected proceeds from selling the
business today.
¨ 
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So what is the fair value? You be the judge
We now have five estimates of fair value for this firm.
Which of the following is the “right” fair value?
q  $ 800 million: Intrinsic value, with status quo.
q  $ 1250 million: Intrinsic value, with optimal management
q  $ 980 million: Expected intrinsic value, with probability
of change built in
q  $ 750 million: Relative value, based upon sector multiple
q  $ 600 million: Relative value, adjusted for illiquidity
Why?
¨ 
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So, what is FASB’s vision?
Glimmers from FAS 157
¨ 
¨ 
¨ 
The ubiquitous “market participant”: Through the entire statement,
homage is paid to the ubiquitous market participants and what they think
about risk and will be willing to pay for an asset. In effect, accountants are
asked to attach values to assets/liabilities that market participants would
have been willing to pay/ receive.
Tilt towards relative value: “The definition focuses on the price that would
be received to sell the asset or paid to transfer the liability (an exit price),
not the price that would be paid to acquire the asset or received to assume
the liability (an entry price).” The hierarchy puts “market prices”, if
available for an asset, at the top with intrinsic value being accepted only if
market prices are not accessible.
Consideration of illiquidity: Accountants are asked to give consideration to
specific restrictions on the sale/use of an asset in valuing it. Presumably, if
there are restrictions on selling an asset, the value will have to be
discounted for illiquidity.
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My Road map for fair value accounting (as a
user)
The ultimate role of accounting is to provide
investors who follow a company with information
that they can use to estimate value and measure
performance.
¨  Fair value accounting done right should make it
easier for investors to value companies, not more
difficult. It should follow these principles:
¨ 
¤  Do
no harm.
¤  Don’t overreach.
¤  Keep it simple.
¤  Less is more.
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Do no harm…
¨ 
The fundamental questions: Financial statements should (and have
been designed to) answer three questions:
¤ 
¤ 
¤ 
¨ 
How much did you earn last year?
What do you own and how much did you invest to get what you own?
What do you owe?
In the process of moving to fair value accounting, we should not lose
information that has been used to answer these questions. Therefore:
¤ 
¤ 
¤ 
Replacing existing book values of assets (which measure capital invested) with
the fair or market value of those assets replaces a useful piece of information
with one that is redundant (if it just reflects market value), misleading (if it
incorrectly tries to reflect market value) or confusing (if no one is quite sure).
Adjusting earnings for past mistakes in fair value assessment (inevitable with all
fair value accounting) will make earnings less informative.
Trying to include potential, possible and imagined liabilities in balance sheet
dilutes the meaning of debt.
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Focus.. And don’t over reach
■ 
■ 
■ 
Be clear about what you want to accomplish : Fair value
accounting has to be clear about what it is trying to
accomplish. Rather than reaching for the ultimate, settle for
the incremental.
Be realistic: Accept the proposition that an accounting
statement cannot be all things to all people. It will always be a
reflection of the past and lag both intrinsic and market value.
Don’t over reach: Accounting statements will not replace or
even compete with market values and book values will be
poor replacements for market values. Accountants are not
(and should not try to be) analysts, appraisers or evaluators.
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Keep it simple
■ 
■ 
■ 
Stick with the easy assets: The assets that can be valued with
simple rules should be the first targets. Assets that will require
complicated or complex rules are best left untouched.
Let others deal with complex assets: Provide the information
(or raw data) for assessing fair value but don’t take on the
responsibility of doing it yourself.
Principle based valuation, not rule based valuation: Less rules
and more focus on first principles will lead to better
valuations.
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Less is more…
Data is not information: Financial statements are
increasingly becoming data dumps. There is little
evidence that that 10Ks of today are more
informative than the 10Ks of 20 years ago, but they
are definitely more voluminous.
¨  Prioritize: Not all information is equally important.
The level of detail (and effort spent) on any item
should be proportionate to its importance.
¨ 
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